My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Thursday, May 17, 2012

Facebook and "Field of Dreams": Hoodies, Hubris and Hoopla

In mid-February, I posted my valuation of Facebook and my thoughts on what would happen at the IPO. Since the actual offering date is tomorrow and the frenzy mounts, I thought it would make sense to revisit those posts.

1. Valuation Update
In my February 16 post on the company, I attached my valuation of the company, based on the S-1 filing as of that date. Quickly reprising that valuation, I valued the equity in the company at $29/share (assigning an overall value of about $72 billion for Facebook's equity), with the following key assumptions:
a. Revenues growing to $44 billion in ten years, with a compounded revenue growth rate of 40% for the next 5 years, fading down over time
b. A pre-tax operating margin of about 35%, higher than Google's 30% and on par with Apple
c. Reinvestment (in internal projects and acquisitions) that generate a $1.50 in revenue for every dollar in capital.
d. A cost of capital of 11.42% initially, fading down to 6.50% in steady state

So, what have we learned about Facebook in the last three months that may change this valuation?a. Facebook wants growth and will pay for it: Facebook has acquired three companies in the last couple of months, Instagram, Tagtile and Glancee. While the Tagtile and Glancee deals were a continuation of a long term strategy of buying small firms with technologies that augment the Facebook experience, Instagram represented a new front: a "more" expensive acquisition of a company that brought with it potential "new users". My guess is that a publicly traded Facebook, with access to far more capital, will continue making acquisitions with the intent of delivering promised revenue growth and that the pace (and the size) of acquisitions will pick up if (or as) internal growth slackens. That is mixed news for investors: the good news is that it increases the odds that the predicted growth in revenues will be delivered but the bad news is that Facebook may pay more for this growth than anticipated.

b. Mark Zuckerberg is lord and master of this company: While there has never been any doubt about the autocratic power structure at Facebook, the last three months have brought home that this is Zuckerberg's company. If news stories are to be believed, the decision to buy Instagram (at least at the final price) was made by Zuckerberg, with little input from the board. If you are going to be a stockholder in Facebook, you should get used to this scene being played out in small and big ways over the next few years.

c. The "Field of Dreams" business model: Finally, Facebook's value still lies in its promise, rather than in actual numbers. Remember the line from the movie, "Field of Dreams", where Kevin Costner wanders through a corn field and hears a voice that tells him that "if you build it, he will come". With Facebook and other social media companies, this line can paraphrased as "if you get the users, they (products, advertising) will come". While I do not want too much of a single story, the news story of GM abandoning its Facebook advertising should provide a cautionary note to the optimistic view that Facebook can easily convert its monstrously large user base into advertising fodder.

Bottom line: Revisiting the valuation, there is not a great deal I would change as a result of news over the last few weeks: a higher revenue growth rate (45% compounded with revenues growing to $ 56 billion) accompanied by lower margins (30%) and more reinvestment ($1.25 of revenues for every dollar invested) delivers an estimate of value that stays at the $70-$80 billion range.

2. Pricing (IPO) Update
When I labeled this the "IPO of the century" in February, I was speaking tongue in cheek. After all, the century is young and there are other IPOs to come. While there is little that you will learn about the value of the company from the IPO process, there is a great deal that we can learn about human behavior and the ecosystem that feeds off big deals.

a. The bankers will do anything to be part of a "big deal": As you track the news stories, it is quite clear that the bankers need the Facebook deal more than Facebook needs the bankers. In fact, I am quite surprised that Facebook did not follow the Google model and bypass the investment bankers entirely and set up an auction. I think that the only reason that they chose to follow the conventional route is because investment banks are essentially doing this deal at cut rate prices and bending to Facebook's will at every turn..

b. And Mark Zuckerberg know it: As someone who has never been comfortable wearing a tie or a suit, I must confess that I found the brouhaha over Zuckerberg's hoodie to be hilarious. I don't particularly care for Zuckerberg's corporate governance, but I, for one, have never believed that your professionalism is determined by what you wear. I am sure that Bruno Iskil, who lost billions for JP Morgan, wore a very expensive suit, while making his trades. I think Zuckerberg, in addition to mimicking one of his idols, Steve Jobs, was sending a message to Wall Street about who has the upper hand in this game.

c. Investors are replaying an age-old phenomenon: Individual investors are clearly caught up in the mood of the moment, lining up to get allotments of Facebook shares. Is it a bubble? Who knows? If those who forget history are destined to repeat it, it sure looks like a replay of events from the past, and for those who do no remember them, I have a reading suggestion.

d. The insiders: While I don't assume that insiders are infallible, it is telling that they are heading for the exits at the same time as individuals are piling in. Is it possible that they think that the stock is being priced at the top end of the value range? Do they not trust Mark Zuckerberg? Inquiring minds want to know and i guess we will find out as events unfold.

Bottom line: I don't think that there has ever been an IPO where investment bankers have had more information (from private share market prices to institutional investor feedback) to work with, when pricing the stock, than this one. I would be very surprised, if the stock were overpriced; the bankers and the company have too much too lose. I would be equally surprised if the stock were dramatically under priced; a pop of 50% or even 25% would reflect very badly on the bankers' pricing skills. In short, this is shaping up to be a Goldilocks IPO, at least in the initial hours: a pop of about 10-15% (just right for both the bankers and the company). The question is how long the pop will last. This company is too big and too public to stage manage in the weeks after the IPO. If the pop fades quickly, perhaps even by the end of trading tomorrow, I think it is a very bad sign for the momentum game in all social media stocks.

3. Investment strategies
So, what should investors do about Facebook? You can play the IPO game, and I have described some of the ways you could do it, in an earlier post. Generically, here are the four strategies you can adopt:a. Short term buy: It may be too late for you to get in at the offering price, but if you believe in the short term momentum story, you can buy right as the market for Facebook opens tomorrow morning, hope to ride the crest of the price move up as other investors doing the same and exit before they do.b. Short term sell:If you think that the hype is overdone and that disappointment will set in very soon, you can sell short right after the market opens tomorrow, especially if it does not open with a significant pop, with the intent of covering in the next week or two.c. Long term buy:You may be a believer in Facebook's potential and its capacity to dominate the advertising market and to sell products to its users. If so, you should buy sometime in the near future and hold for the long term. How long will you have to wait to see profits? It depends on how quickly Facebook converts its potential to large revenues and profits... could be a year.. could be five..d. Long term sell: If you do buy into my "Goldilocks IPO" scenario and come up with an estimate of intrinsic value close to mine, though, the investment with the best odds of success on Facebook would be a "long term, short" position on the stock.

Bottom line: I think that the hype is overdone, that disappointment will set in sooner or later and that the stock has far more downside than upside. You can put me in the last group (long term sell) though I am still searching for the most efficient (and least costly) way to execute this.

4. Broader implications
Does the Facebook IPO have broader implications for the overall equity market? I have heard arguments that a successful Facebook IPO will lead to a rebirth of faith in equities among investors and be a shot in the arm for financial service firms. I think that is nonsense.

If Facebook does launch successfully tomorrow and the stock price goes up 10%, 20% or even 30%, I don't see how it will cause risk averse investors to come back to stocks. In fact, it will probably feed into their suspicion that the stock market has become a casino that they cannot trust their savings in.

As for investment banks, a successful Facebook IPO may bring in some fees and commissions but it will not be a reflection of their skills at pricing or deal making. This is a stock that priced and marketed itself, with little or no help from the investment bankers.

In the same vein, a failed IPO (and I will leave you to define what failure means) will have implications for the pricing of social media companies but not much more.

Bottom line: Facebook, in spite of its ubiquitous presence in our lives, is just one company and not a very big one (at least in terms of revenues and earnings) yet. The market will obsess about it tomorrow but it will move on very quickly to the next worry, fear or fad.

54 comments:

The problem with overhyped over priced companies is that they can remain overhyped and priced long enough before sanity kicks in. Also, i am sure the acquisitions will keep pushing the revenue higher...for atleast the next couple of weeks /months (linkedin recent example) the company may not come dowm too much... unless the crisis is played out (Europe)....Ideal time to short this may be when a new product with Facebook type hype is launched. I am not sure if Facebook is going to dominate the` social media for the rest of our lives... true it has gained momentum beyond comparison but so did Nokia and Sony.......

I'm not sure you can do a pure "valuation" on Facebook. There is so much more to it, including and not forgetting growth from China, India, South America and Asia. not to forget that Mark will probably buy other types of company's which differ from his core business. I see Facebook becoming a goliath overtime. Think Google or Apple.

Bonsai,I am not sure what you mean by a pure valuation. Are you telling me that there is a lot that can happen in the future that you cannot forecast? Sure. Some of it is good. Some of it is bad. That is the nature of valuation.

I believe 2% as terminal growth rate is low. Given that the a large proportion of the advertising revenue would come from global customers (especially 10 years down the line), I would be more comfortable with a 4% growth rate in the terminal case (1-2% real growth +2-3% inflation) . Curiously, the valuation in this case starts to get errily close to the IPO price if other assumptions are kept same

You cannot change the terminal growth rate, while leaving the rest of the inputs unchanged. If your argument is that there is global growth, it has to show up as a longer growth period. In fact, setting your terminal growth > risk free rate is a definite no-no in DCF valuation.

Pardon me for posting this under the wrong blog entry, but I wanted to know where I can find your arguments for investing in Microsoft. (At the end of your Apple entry, you wrote that you had recently become a shareholder of Microsoft). Could you please point to the right place if you have already published it somewhere or otherwise summarize your thoughts on this?

My belief is the IPO has peaked the growth curve and we should see probably a humble growth in near term and slower or negative growth into the future. especially so for the fast and ever changing technology sector.

Awesome post Prof. Damodaran. I was feeling lazy, I used moneychimp's DCF calculator, with my assumption that growth for FB will dramatically slowdown within the next 5 years, if not sooner. Moneychimp spitted out a value of 30.12 #/ sh. I see that your valuation assumptions have a lot of hard ground to stand on, so I'll wait the the stock hit 29$. After subtracting a margin of safety of 5%, my bid would be around 27.5$/sh. Mr. Market may not agree with me for now, then again almost everyone on the street is pumping air in his chest that FB is a steal at 38$.

1. To point out that faster growth is possible for a longer duration, and 2. More importantly, the valuation is sensitive to the long term growth assumption Your post seemed to imply that facebook's IPO price is definitely over valued. However assumptions may vary in the market and market price is determined by average of these assumptions (implicit or explicit) even if some assumptions are irrational.

Also wanted your input on the following

1. Discount rate, given that majority customers and future earnings could be non us (my brother in india uses fb to advertise his startup rather than Google as he believes it provides better targeting for his startup)

2. Risk free rate: any implications of the fact that the risk free rate as manifested today in us treasury bond yields is lower than what it normally is because of irrational global risk off phenomenon and money being parked in us treasuries

RW,That is a fair point. I don't ever use the word "definitely" in the context of valuation. I think it is possible to always find a set of assumptions to justify almost any value. The key when investing is to invest based on probabilities, not possibilities.

Thank you for sharing your valuation model (Btw, there are references to Groupon in the spreadsheet, I presume you mean Facebook.)

My primary question is around the 40% compounded growth rate. How did you come about that number?Facebook only has access to about 10% of the ad market - users don't discuss money, cars or health on Facebook out of privacy concerns, and don't click on ads in these categories as well.

This is easy math. Supply and demand. There is a vast supply of shares that few will demand now, in light of the IPO debacle. Facebook stock will nose-dive, and never recover. Their IPO is a subject of ridicule in the public eye, and that public is leery of being associated with same. Sellers will far outweigh buyers, and this will not change over time. Just my $.02.

I have a bit more dire price target on this stock. Cannot see how one can put a 70 Billion dollar valuation to this "business" - more in the link below http://kennethserrao.wordpress.com/2012/05/20/facebook-target-price-0-why-i-dont-like-the-stock-26/

I think the current FB valuation discussion and disagreement is an interesting psychological phenomenon:

The valuation levels of this stock have been around for almost half a year. Analyst have priced this stock at the upper range and institutional investors around the globe bought it based on their analyses, believing it is undervalued at their purchasing prices. Now, suddenly some people think this stock is overvalued. Why? Maybe here are some explanations:

1. Mainly retail investors and journalists (people with less valuation experience of growth companies) suddenly (quite late, at the time of the IPO) realized the company hit the $100 bil-lion market cap, which is a magic barrier for them.

2. This causes them and other investors (influenced by them) to think about the "right valua-tion" by comparing it mainly (and mostly only) to other (similar) stocks and similar large IPOs etc. instead of analyzing the fundamental business model and long-term growth prospects of the company.

3. Hedge funds with short strategies influence this overvaluation discussion and short the stock which increases the doubts of the investors on the level of valuation.

4. Journalists, bloggers (self-made journalists :)) and media companies are profiting from this big overvaluation story as well which increases the overvaluation sentiment.

5. Investors, these days, tend to be very skeptical towards new issues in general (which is re-flected by the current weak IPO market) and undersatandable, considering the dot-com bubble crash in 2000. This is more true for historic and large IPOs and for dot-com companies like FB with mainly future values.

6. Aversions and/or jealousies towards the recent success of the company and the CEO con-tribute to the overvaluation discussion.

7. Uncertainty based on the lack of information about the future leads to conervative values assuming risk averse investors, although this uncertainty has not just come up at the IPO date.

Apart from the more rationale point 7 above I think the overvaluation assessment is too much based on emotions: fear of size and power, greed (short sellers), antipathy (company, CEO) and pseudo-professionalism: it seems suddenly everybody is a valuation expert and a top-manager of an Internet company.

Valuation of "hope" and "vision" is difficult, but assuming Zuckerberg is a great visionary and somebody that has created a network with the intention to replace the Interconnected Network of machines with an Interconnected Network of Humans/Individuals (Facebook) that will exist as long as mankind? Imagine how many Internet services and other companies (data services/cloud companies, search engines, shopping (e-commerce) portals, payment transfer companies, telco companies etc.) will be superfluous? Just add up the market cap of some of these larger players or their revenues (and a fraction of their cost) and do the valuation math: it's not only about the growth of the advertising revenue through smart marketing ideas that makes up the valuation of FB - it is the (step-by-step) change of the Internet business model and the surrender of many companies at the benefit of FB. The value of FB is a classical out-of-the-box thinking issue: a market value of $500 bn could be easily justified.

Let me relativize my last posting: I think although value is subjective and different to each individual - there should be a common (worldwide) standard for an objectified company value like it is partially common practice under appraisers in expert opinions, i.e. to value the company under the going concern assumption, an unchanged business model (stand-alone), considering only already introduced measures (acquisitions, divestments, business model changes etc.) with realistic expectations for the future as part of its market opportunities and risks etc.

Such an objectified company value could be (today) in fact around $50 bn or $20 per share.

However, on the stock exchanges a market valuation is being created by all buyers and sellers which depends on each individual value concept which is based on individual valuations of "hope and visions". If more market participants believe in the visionary Mark Zuckerberg than those that don't believe, than the stock market valauation will be more likely $500 bn than $50 bn. Similarly to the value of our currencies: if people have no faith in their economy (economic performance) and anticipate inflation there will be inflation per definition.

In summary Facebook is religion, philosophy and psychology and a little bit of mathematics.

You really don't need much of a model to value this bubble. Lets be generous and price it at 10x revenue. Much much much larger than apple's, google's and amazon's. What do you get? $13. It's coming. Give it a month.

Prophetic Article! starting form premium for barely a few hours after IPO to the decline in price to the expected levels. Had it not been an IPO many would have thought that Prof. had some insider information.

Prof Damodaran, I am a student and still learning about Valuation and as I try to quantify the 'Intrinsic Value' of a company- I cannot help but think the non-monetary value that would eventually turn into more revenues.

I see companies and what 'value' they've added, if they are gone- will we miss them. And I thought the pricing for facebook was bizarre.

However, I do not conform with what facebook is being criticised for. Today on CNBC, Investors do not like facebook focusing more on building user experience and not on advertising.

I currently pay $7 for a Hulu Plus subscription and $20 for a Netflix conenction per month. I would be more than happy to pay a price for a Social Media site with no advertising. Of course, there needs to be demographic profiling, emerging market strategy differences (focusing on advertising) but what I am saying is- Mark Zuckerberg is being criticised for the wrong reasons and yes- he surely needs to get an 'Eric Schmidt' but I have faith his statement is more to let people know that 'facebook ain't going to turn into another myspace'. I would add a 'premium' not a 'disocunt' for this.

We are two students writing a master thesis about the long-term performance of IPOs. We have found long-term unperperfomance of Norwegian IPOs ranging from 10%-30% and we are wondering if it is possible to exploit this?

We wish you could clarify if you think it is possible to take a long-term (three years)short position and still make a profit from a situation like the Facebook IPO (after transaction costs)?

You stated the following in your entry from the 17th: "I would be very surprised, if the stock were overpriced; the bankers and the company have too much too lose."

I'm curious, exactly what has MS, the other underwriters, and FB lost by overpricing this IPO? Some argue MS has profited off the over-allotment, and FB has it's capital raise. Where's the downside to overpricing in this, or any other, IPO? Thanks!

The IPO is just the opening inning in a much longer game. Only 18% of the shares outstanding were offered in the IPO and the post-IPO collapse makes the remaining 82% not only less valuable but more difficult to unload. The investment banks may have collectively made $100 million on the deal, but split it up among the syndicate and think about the reputation damage that they have done to themselves, I am sure that they have come out behind. Even the insiders who sold have big stakes left in the firm... So, I don't see any winners...

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>>>>>>>>>>>>>>1. Valuation Update.....Quickly reprising that valuation, I valued the equity in the company at $29/share (assigning an overall value of about $72 billion for Facebook's equity), with the following key assumptions:a. .......<<<<<<<<<<<<<<<<<<<<<<<<

any updates professor ? price as of now is circa 23.10 per share ..

what are the two / three main assumptions you would change should you do the sp sheet today ?